U.S. stock plunge raises alarm on algo trading

NEW YORK (Reuters) - A spine-chilling slide of nearly 1,000 points in the Dow Jones Industrial Average, its biggest intraday points drop ever, led to heightened calls for a crackdown on computer-driven high-frequency trading.

The slide, which in one 10-minute stretch knocked the index down nearly 700 points, may have been triggered by a trading error. Major stock indexes eventually recovered from their 9 percent drops to close down a little more than 3 percent.

But the follow-through selling that pushed stocks of some highly regarded companies into tailspins exacerbated concerns that regulators can quickly lose control of the markets in a world of algorithmic trading.

High-speed trading, which uses sophisticated computer algorithms based on specific scenarios to automate transactions at speeds in the millionths of a second, now accounts for about 60 percent of U.S. equity volume.

"The potential for giant high-speed computers to generate false trades and create market chaos reared its head again today," Senator Edward Kaufman said in a statement.

"The battle of the algorithms -- not understood by nor even remotely transparent to the Securities and Exchange Commission -- simply must be carefully reviewed and placed within a meaningful regulatory framework soon."

Kaufman and Senator Mark Warner -- both Democrats -- said Congress needs to investigate the plunge, which at its deepest point wiped nearly $1 trillion off equity values.

And a House panel has slated a hearing on the causes for the market swoon for next Tuesday, with its chairman, Rep. Paul Kanjorski, urging the SEC to investigate as well.

The scary afternoon in markets came at a bad time for Wall Street, already reeling from accusations that it is a rigged casino -- a criticism stoked by recent civil fraud allegations against Goldman Sachs Group Inc (NYSE:GS - News).

The industry has been trying to stave off the Obama administration's calls for tough financial regulation, and the sell-off came as the Senate turned back a Republican effort to weaken a plan to set up a financial consumer watchdog.

SOME TRADES TO BE Canceled

Lending credence to the sense that the sell-off was exacerbated by technical errors, the Nasdaq stock exchange and NYSE-Arca said they would cancel certain trades that happened during the period in question.

But only trades in stocks that moved 60 percent up or down were covered by the cancellations, leaving some investors with potentially major losses on stocks such as Apple Inc (NasdaqGS:AAPL - News) and Procter & Gamble Co, which suffered lesser, but still significant, declines.

The U.S. Securities and Exchange Commission and Commodity Futures Trading Commission said they were reviewing the unusual activity and working with the exchanges to protect investors.

Citigroup Inc (NYSE:C - News) said it was investigating a rumor that one of its traders entered the trade, a spokesman for the bank said on Thursday. Citigroup, the third-largest U.S. bank, said it has no evidence that an erroneous trade has been made.

Several market participants cited speculation that a trader at Citigroup had erroneously placed an order for at least $16 billion in E-Mini contracts -- stock market index futures contracts that trade on the Chicago Mercantile Exchange's Globex trading platform.

But a source familiar with the situation said Citigroup had traded a total of just $9 billion of the E-Mini contracts, adding that that amounted to less than 3 percent of the $319 billion traded on the E-Mini on Thursday.

CME said the bank's trades in CME index futures appeared normal.

'SCREWED UP'

Earlier, sources told Reuters that the plunge in the Dow Jones Industrial average may have been caused by an erroneous trade entered by a person at a big Wall Street bank.

During the sell-off, Procter & Gamble shares plummeted nearly 37 percent to $39.37 at 2:47 p.m. ET (1847 GMT), prompting the company to investigate whether any erroneous trades had occurred. The shares are listed on the New York Stock Exchange, but the significantly lower share price was recorded on a different electronic trading venue.

"We don't know what caused it," said Procter & Gamble spokeswoman Jennifer Chelune. "We know that that was an electronic trade ... and we're looking into it with Nasdaq and the other major electronic exchanges."

A different P&G spokesman had said earlier the company contacted the Securities and Exchange Commission, but Chelune said that he spoke in error.

One NYSE employee leaving the Big Board's headquarters in lower Manhattan said the P&G share plunge lay at the center of whatever happened.

"I'll give you a tip," the employee said, speaking on condition of anonymity. "P&G. Check out the low sale of the day. Something screwed up with the system. It traded down $30 at one point."

A vicious market sell-off like Thursday's can be exacerbated when quickly sliding stock prices turn stop loss orders into market orders, meaning shares get sold at any price available.

WIDE SWINGS

NYSE Euronext (NYSE:NYX - News) said it was a safer place to trade than its electronic rivals -- who have been taking market share from it in recent years -- because it deliberately slowed down market making when it realized there was something extraordinary happening.

Triggered by unusual volatility in some stocks, NYSE brought in a "mini circuit-breaker" -- a liquidity refreshment point, or LRP -- to slow trading, which then jumped to other, fully electronic exchanges.

"It validates the decision to offer a hybrid market here where there's a human component married with the electronic," Louis Pastina, executive vice president of NYSE Operations told Reuters in an interview.

The market plunge and especially wide swings in some individual stocks reignited some wider criticism of high-frequency trading, a strategy using lightning-fast computer programs to track market trends.

"We did not know what a stock was worth today, and that is a serious problem," said Joe Saluzzi of Themis Trading in New Jersey, a frequent critic of computer-driven high frequency trading.

Investors had already been on edge throughout the trading day after the European Central Bank did not discuss the outright purchase of European sovereign debt as some hoped they would to calm markets.

While the exchanges' move to cancel some of the most suspect trades may mollify some, there remained more questions than answers about the market's wild afternoon.

"The trouble is the exchanges aren't saying what caused the erroneous trade," said James Angel, a professor at Georgetown University's McDonough School of Business who specializes in market structure. "What they are saying is that it's not my fault, it was somebody else's fault."

Why can't people accept the fact that what happened during the crash was real? All theories involving a fat finger, or Terra Nova, or whatever else, have been refuted. The HFT machines can only make profit with volatility below a certain level. If it exceeds that level, they stop trading. If NYSE decides to slow down for price discovery reasons, the other exchanges will have a liquidity trap. So the price drop will speed up until NYSE catches up. There is nothing illegal or manipulative here. Just how the markets work today.

HFT shouldn't be forced to trade if they don't want to. Just like any other trader they have the right to stop trading (providing liquidity) and walk away. Besides that sell off took time, it wasn't like it happened in milliseconds. intra day traders had time to get out. I don't feel sorry for anyone who blew out on Thursday.

Any type of short term high leverage trading is at the mercy of black swan events. No one said you have to try to pick up pennies in front of the bulldozer.

Only risk % of account per day for trading. So in the event of a black swan event you can somewhat protect your account. Always be near your computer and be ready to pull the plug on any type of trading as soon as you exceed your risk parameters.

trade options , limited loss and unlimited profit. and trade small for small traders in these markets..very illiquid

futures or or any leveraged hedging...still wiped like what happened on october/ november 2008 and may 6, 2010 a black swan blue moon which happens only every 20-25 years or a generation

Quote from TokyoGhetto:

well said.

HFT shouldn't be forced to trade if they don't want to. Just like any other trader they have the right to stop trading (providing liquidity) and walk away. Besides that sell off took time, it wasn't like it happened in milliseconds. intra day traders had time to get out. I don't feel sorry for anyone who blew out on Thursday.

Any type of short term high leverage trading is at the mercy of black swan events. No one said you have to try to pick up pennies in front of the bulldozer.

Only risk % of account per day for trading. So in the event of a black swan event you can somewhat protect your account. Always be near your computer and be ready to pull the plug on any type of trading as soon as you exceed your risk parameters.

The vix where it is now is going to force HFT and MMs to either quote wider or not quote at all. Well some can walk away some have to quote regardless due to exchange obligations.

Imagine you are a MM or HFT firm and you can quote a market $1 dollar (100 cents) avg deep from the opening print. Now imagine that the stock you make a market in now trades $3 dollars (300 cents) avg deep from the opening print. You have to quote a min size (say 1000 shares) every cent from the current NBBO.

Even quoting a market 40 cents deep would result in a negative PnL of -$8200. (thats $-8.20 combined, holding 40000 shares of inventory and trading at a tick value of $400 on your position, break even point being 20.5 cents from the last traded price.)
Not exactly chump change. These numbers grow as you increase the depth of in which one is willing to quote a market.

So some firms aren't willing to take on that risk and are just walking away, mostly prop firms that don't have an obligation to quote a market but who use liquidity providing as a strategy.

You either quote wider to compensate for the volatility , or walk away. Remember, quitting while you are ahead is not the same as quitting.

leverage is dangerous.
Hedging is never 100%.

If you aren't ready to lose 100% of your trading account, then stop trading completely because you obviously failed trading 101, only trade with money you are willing to lose.